The PRC State Administration of Taxation and Ministry of Finance jointly issued a tax circular on 25 December 2009 ("Notice on Foreign Tax Credit Issues for Enterprise Income Tax", Caishui [2009] No. 125 (Circular No. 125)) that interprets the foreign tax credit (FTC) rules as provided in articles 23 and 24 of the Enterprise Income Tax (EIT) Law. This article summarizes the key points of Circular No. 125, as well as our observations, to facilitate readers' understanding of the new rules and keep pace with recent developments and changes to the PRC FTC regime.

 

 

 

 

Circular No. 125 does not provide further guidance on the determination of the source of income.  Instead, it emphasizes that, for foreign branches without separate taxable status (defined below) of a Chinese company, the foreign-source income of the branch should be included in the Chinese company's taxable income of the current period, regardless of whether the income is actually repatriated back to PRC.  Meanwhile, the relevant taxable income should be calculated according to the EIT Law and its implementation rules.  In addition, article 3 of Circular No. 125 provides that common expenses incurred for both PRC and overseas income must be allocated based on a “reasonable percentage” to calculate the PRC and foreign-source taxable income separately.  It is not entirely clear, however, what is meant by "reasonable percentage", and whether that percentage would need to be approved by the authorities.  We believe that further detailed administrative measures will be provided in this context.

 

For passive income (such as dividends, interest, royalties, rents and capital gains, etc.), Circular No. 125 specifies that deductions attributable to passive income should follow the EIT Law and its implementation rules.  However, it is not entirely clear on what basis (i.e. foreign rules, PRC GAAP or the EIT Law) such passive income should be recognized.  In addition, Circular No. 125 does not specifically address the FTC issues for a deemed dividend distribution from controlled foreign corporations of a Chinese company.

 

 

 

The following types of expenditure, as listed in Circular No. 125, do not qualify for the foreign credit:

 

·         Foreign income taxes that are wrongly paid or collected under foreign income tax laws and regulations;

 

·         Foreign income taxes that will not be paid due to the application of a tax treaty;

 

·         Interest expense, overdue charges and penalties due to an under-payment or a late payment of foreign income taxes;

 

·         Foreign income tax refunds or compensation actually received by the foreign income taxpayer or its related parties from the foreign tax authorities;

 

·         Foreign income taxes arising from foreign-source income that is exempt from PRC tax under the EIT Law and its implementation rules; and

 

·         Foreign income taxes that have been deducted from foreign-source taxable income pursuant to relevant regulations from the finance or tax authorities under the State Council.

 

Circular No. 125 also provides that any income that is tax exempt or the rate is reduced under a preferential tax regime in a foreign country but deemed paid on the foreign-source income pursuant to a tax sparing provision in a relevant treaty should be taken into account as foreign income tax available for credit.

 

Although Circular No. 125 reiterates that such foreign income tax refers to any foreign tax in the nature of an enterprise income tax, and that should be and have been actually paid according to foreign tax law and regulations, no definition of the "nature of an enterprise income tax" is provided.  We expect this definition to be clarified in follow-up regulations.

 

 

Article 6 of Circular No. 125 provides that an indirect FTC is limited to three tiers, that is

 

First tier: a foreign company with at least 20% of its shares held directly by a single resident company;

 

Second tier: a foreign company with at least 20% of its shares held directly by a single first tier foreign company, and in the aggregate, at least 20% of its shares are held directly or indirectly by a resident company via one or more foreign companies satisfying the above shareholding requirement;

 

Third tier: a foreign company with at least 20% of its shares held directly by a single second tier foreign company, and in the aggregate, at least 20% of its shares are held directly or indirectly by a resident company via one or more foreign companies satisfying the above shareholding requirement.

 

We understand that the three tiers of overseas companies should include intermediary holding companies.  However, some intermediary holding companies may be "looked through" under general anti-avoidance provisions or similar rules.  In such cases, it is not clear whether the "look through" rule should also be applicable in the FTC context.  In addition, some overseas companies could be Chinese resident companies under the "place of effective management" test (such as stipulated in Guoshuifa [2009] No. 82) so that the determination of tiers may become more complicated.  Compared with other countries, the three-tier FTC regime seems to be limited (for instance, a six-tier credit is permitted in the U.S.).  But we understand the three-tier regime is more practical and easier to be implemented considering the current Chinese outbound investments status.  With more Chinese companies going overseas, as well as the tendency of multi-tier structures being adopted by Chinese companies, it is possible for the limitation to be relaxed in the future.

 

 

Circular No. 125 provides the following formula to calculate the indirect credit:

 

Foreign tax paid by the foreign company in the current tier but attributable to dividends received by the tier above = (foreign tax paid on profits and gain from equity investment in this tier ＋ foreign tax paid by the foreign company of the tier(s) below, but attributable to the dividend income received by the current tier) × Dividends repatriated to the above tier ÷ After-tax profit in this tier

 

If this formula is used to calculate the FTC limit in a multi-tier situation, the timing of taxes and the repatriation of after-tax profits accumulated in each level and ultimately passed on to PRC holding company could be different.  Thus, it is necessary to have a mechanism to track the tax and after-tax profits by entity and by year (such as a pooling system, FIFO principle, etc.).

 

 

 

Circular No. 125 reiterates that the FTC limitation in article 78 of the implementation rules of the EIT Law is to be computed on a per-country basis, according to the following formula:

 

FTC limit for a particular country = Total tax payable computed on income sourced in and outside PRC in accordance with the EIT Law and implementation rules × Taxable income sourced from a particular country ÷ Total taxable income sourced in and outside PRC

 

The tax rate applicable to the "Total tax payable computed on income sourced in and outside PRC in accordance with the EIT Law and implementation rules" in the formula is the statutory rate stipulated in the article 4 of the EIT Law, i.e. 25%, unless otherwise specified by the government authorities.

 

The principle is also followed to allocate any common expenses among domestic and foreign-source taxable income.  In addition, Circular No. 125 provides that, when calculating the total foreign-source taxable income of a Chinese company, losses (calculated pursuant to PRC EIT Law and implementation rules) incurred by an overseas branch without separate taxable status will not be offset against profits derived from PRC or other countries.  However, such losses may be offset against the income derived from other projects of the same country or income from subsequent years.

 

 

Article 17 of the EIT Law provides that losses incurred by overseas operating branches should not be offset against domestic profits.  However, Circular No. 125 introduces the concept of "foreign branches without separate taxable status", and similarly provides that losses of such foreign branches should not be offset against domestic taxable income or taxable income derived from countries other than where the branch is located.  The term "foreign branch without separate taxable status" is defined in Circular No. 125 as a non-legal person pursuant to the foreign laws or an entity that does not qualify as a tax resident pursuant to a relevant tax treaty.  In practice, this definition may not be sufficiently clear.

 

Circular No. 125 further regulates that, when the sum of the total taxable income derived inside and outside PRC based on the EIT Law and implementation rules is less than zero, both the total taxable income and the FTC limit should be treated as zero.         

 

 

 

Circular No. 125 explains the approach of FTC calculation as follows:

 

·         Calculate the amount of domestic and foreign-source taxable income on a per-country basis;

 

·         Calculate foreign income tax available for a credit and the FTC limit on a per-country basis;

 

·         For a particular country, when the foreign income tax available for credit is less than the FTC limit, the resident company will be allowed to credit its tax payable with the amount of such foreign income tax; otherwise, the resident company will be allowed to credit the tax payable with the amount of the FTC limit.

 

 

As mentioned above, Circular No. 125 provides that if the FTC amount in a particular country cannot be calculated accurately, no FTC should be taken by the Chinese company for taxes paid in that country in the current period or carried over for future credit.  In this case, the resident company may be subject to double taxation on its foreign-source income.  Because it may be difficult to define "accurate calculation" in practice, it would be helpful if the tax authorities provided additional guidance.  In addition, a prerequisite for "accurate calculation" is that the taxpayer understands Circular No. 125 correctly and thoroughly.  Since the provisions in Circular No. 125 are complicated (such as the application of indirect FTC, etc.) and applicable retroactively as from 1 January 2008, it would be a significant challenge for both the competent tax authorities and taxpayers to implement the circular without further guidance.

 

 

Circular No. 125 provides that under the following situations, the competent tax authority may approve an enterprise's application to use a simplified approach to calculate the FTC:

 

·         For foreign-source business profits and dividends that are eligible for an indirect FTC, where the taxpayer cannot determine the relevant foreign income tax payable and paid in the foreign country due to objective reasons even though the taxpayer obtains certain tax certificates or proof from the foreign competent tax authorities, the FTC limit may be calculated as 12.5% of the foreign-source taxable income, except where the effective tax rate with respect to the foreign income tax is lower than 12.5% in the source country;

 

·         For foreign-source business profits and dividends that are eligible for an indirect FTC, where the statutory tax rate and corresponding effective tax rate with respect to the foreign income tax in the source country are significantly higher than the PRC tax rate, the creditable foreign income tax may be the amount of foreign-source taxable income multiplied by the PRC tax rate.  Currently, following countries are listed in Circular No. 125, which are regarded as countries whose statutory tax rate is significantly higher than the PRC: Argentina, Bangladesh, Burundi, Cameroon, Cuba, France, Japan, Jordan, Kuwait, Laos, Morocco, Pakistan, Syria, the U.S. and Zambia.

 

In view of above provision, the simplified approach is only applicable to business profits and dividends (and not other passive income), which is different from the simplified approach allowed by the tax regulations for domestic companies before 1 January 2008.  The number of countries with significantly higher statutory tax rates is also limited.  Although it appears easier for taxpayers to calculate the FTC under the simplified approach, taxpayers may be at risk of not fully utilizing the tax credit.  Therefore, it is advisable that taxpayers consider the cost and benefits before opting for the simplified approach.

 

 

Circular No. 125 provides some guidance in respect of tax administration.  For example, for overseas branches without separate taxable status, if the tax year differs from the calendar year as stipulated in the PRC, the relevant foreign-source income should be included in the year in which the closing date of the foreign tax year falls.  Foreign income tax for other foreign-source income should be credited by the resident company in the corresponding PRC tax year in which the foreign-source income is recognized.  Circular No. 125 further provides that dividends should be recognized on the date of declaration; and interest, royalties, rents and capital gains should be recognized on the date of payment as agreed in the relevant contract.

 

Circular No. 125 is silent on the treatment where foreign income tax is actually paid in the current period but attributed to prior years under foreign tax laws, or where a refund or payment is made in the current period for any over-/under-payment of foreign income tax of the prior periods.  We believe it may not be reasonable to regard these situations as the case where "FTC cannot be calculated accurately" as previously discussed, and taxpayers should have the right to adjust the FTC calculations for the prior periods accordingly.  On the other hand, there are still some other open issues, such as which exchange rate should be used for conversion, etc., which are expected to be clarified in the future.

 

 

Circular No. 125 provides further interpretations on the PRC FTC regime, showing that international tax is certain to become an area of importance and development.  However, there are many open issues to be clarified in the Circular and therefore it is expected more detailed administration rules will be issued in the future.  Accordingly, companies investing overseas (including to Hong Kong, Macau and Taiwan) are advised to pay close attention to this area to ensure the FTC can be calculated appropriately.